October 10, 2010 | Jessica Toonkel, Investment News

Adam Bold, chief investment officer of The Mutual Fund Store, thinks that all the talk about exchange-traded funds is just hype. But last fall, he saw an ETF that interested him: Van Eck Global’s Market Vectors Pre-Refunded Municipal Index Fund. However, when Mr. Bold spoke to the firm’s managers about investing between $100 million and $150 million in the $14 million fund, they cringed, he said.

“They said, “Please don’t,’” according to Mr. Bold. The fund didn’t have the liquidity to handle that large an investment and would have had to keep a lot of it in cash, he said.

“And that’s the problem,” Mr. Bold said. “The ETFs with really unique strategies are often small and don’t have liquidity.”

Mr. Bold is one of a number of financial advisers who, despite the frenzy around ETFs, are reluctant to use them or are staying away from the products altogether. Although assets in ETFs grew to $906 billion last month, a number of advisers cited liquidity issues, best-execution concerns, pricing and how the ETF structure affects investor discipline as reasons why they avoid the products.

And though advisers said their concerns predated the May 6 flash crash — which mainly affected ETFs — they also noted that the event confirmed some of their concerns about the products.

That was also true of last month’s software glitch at NYSE Euronext’s Arca stock market, which caused State Street Global Advisors’ SPDR S&P 500 ETF (SPY) to drop 9.6%. Some trades were later voided.

Clients hear about ETFs in the news and think that they should invest in them, but they don’t necessarily understand how they work, advisers said.

What They Need

“My job is to not to give clients what they want; it’s to give them what they need,” Mr. Bold said.

But most ETF providers, including Van Eck, work with advisers to help them place large trades even if the ETFs are small, said Adam Phillips, managing director at the company.

For large trades, such as the one that Mr. Bold wanted to perform, Van Eck usually puts an adviser in touch with liquidity providers that could facilitate the trade, Mr. Phillips said. He declined to comment on the specifics of Mr. Bold’s situation.

For smaller trades that might have liquidity issues, ETF providers usually will go to the primary market and create new shares, said Glenn Smith, vice president at Van Eck.

Beyond those concerns, some advisers stay away from ETFs because they aren’t convinced that they are getting the best price on the execution of their trades. There have been instances in which thinly traded ETFs have had poor execution for individual and small institutional investors, with executions as much as 10% off their quotes, said Kenneth Gutwillig, chairman of Financial Decisions Inc., which manages $180 million in assets.

“In my opinion, fair execution is very nebulous in the ETF world,” he said. “Although everyone agrees the margins for error are much smaller in very liquid, widely traded ETFs, I have yet to have anyone quantify their execution in a meaningful manner to us.”

Mr. Gutwillig said that he has approached several large ETF providers and some custodians but hasn’t ever received a report on the quality of executing in an individual ETF or a group of them.

ETFs may be a great deal for large institutions that have “supercomputers,” but not necessarily for individual investors, he said.

Sucker Bet

“With ETFs, I’m not sure who I’m trading against, but it’s quite likely that he has a much better computer than I do and hence a much more current valuation for the securities that make up the ETF I’m buying or selling,” Mr. Gutwillig said. “So it’s kind of a sucker bet.”

Advocates think that in general, ETF investors can get good price execution.

“Investors have to be diligent,” said Paul Justice, an ETF analyst at Morningstar Inc.

“If you place a large trade for an illiquid ETF or one that has illiquid underlying holdings, then there is a chance that you will get poor execution.”

A number of advisers avoid using ETFs because they worry that the funds often don’t do a good job of tracking the returns of their underlying benchmarks.

During the market’s volatility last year, tracking error among U.S. ETFs jumped to 1.25%, from 0.52% in 2008, according to Morgan Stanley Smith Barney LLC.

“When I think of an ETF, I think of a wolf in sheep’s clothing,” said Mark Matson, a registered investment adviser with Matson Money Inc., which has $2.7 billion in assets under management and doesn’t use any ETFs. “It’s really just a marketing fad.”

Many asset classes can’t be accessed through ETFs, particularly domestic value and international small-cap value, Mr. Matson said.

“When we build portfolios, we have a significant focus on micro-cap international small value, and those ETFs don’t go deep enough in those sectors of the market,” he said.

Of course, advocates of ETFs often tout their low operating expenses. The average total net expense ratio of equity mutual funds is 1.52%, compared with 0.6% for equity ETFs, according to Morningstar Inc.

But ETFs have other hidden costs that investors need to watch, advisers said.

For example, ETFs, unlike mutual funds, can have wide bid-ask spreads that can contribute to their cost, said Joseph Alfonso, a financial planner with Aegis Financial Advisory LLC.

“You really need to dig into the prospectus to figure out what the spreads are going to be,” he said. “Some companies are better than others in disclosing it.”

Mr. Alfonso uses only ETFs from The Vanguard Group Inc. because they are low-cost and the company discloses those costs, he said.

Many advisers who do use ETFs said that they are very careful about which ones they choose. Specifically, many said that they avoid inverse and leveraged ETFs.

Leveraged ETFs are designed to return a multiple of the daily performance of the stock index that they track. Investors can get hammered by using a buy-and-hold strategy, in some cases even if the stock index rises over time.

Inverse ETFs are built by using derivatives to construct a security that profits from a decline in the underlying index or benchmark.

This year, the North American Securities Administrators Association Inc. put leveraged and inverse ETFs on its watch list of “investor traps.”

“There is a sector of the ETF market that is quite speculative,” said Charles E. Fitzgerald, a principal with Moisand Fitzgerald Tamayo LLC, which has $180 million in assets and uses ETFs selectively.

Some advisers steer clear of ETFs because they think that just by the fact that they trade like stocks, they train investors to trade rapidly, rather than be long-term, disciplined investors, advisers said.

“We think the fact that it has second-by-second pricing encourages people to panic,” Mr. Matson said.

It is up to advisers to make sure that investors understand the importance of long-term investing, even if they use ETFs, Mr. Justice said.

“I think it’s important for any investor to control their animal instincts,” he said. “Just because you can see the volatility doesn’t mean that the ETF is any worse than a mutual fund.”